VQOTW: Claiming VAT on payment of third-party legal costs

My client has been in dispute regarding a road traffic accident between one of his company’s lorries, and another VAT registered business’ lorry. A small claims court has judged in favour of the third-party business, and has awarded them payment for damages, including reimbursement of their legal costs. The third-party is a partially exempt business, and so they would like reimbursement for the net amount of their costs, plus the VAT – will the third party raise a VAT invoice to us for payment of those costs and can my client claim back any of the VAT?

The above scenario is extremely common particularly for those disputes that go to court, where the settlement often includes payment of costs to the claimant.

The first issue is the liability of the payment made by your client to the third party to cover that third-party’s legal costs. There is no supply made to your client in return for that payment, so it is outside the scope of VAT, and therefore the third party should not raise a VAT invoice for that payment.

So, can your client claim back any of the VAT charged by the third-party’s solicitor to the third party? The simple answer is no they can’t – the reason they can’t is because under the direction of supply principles, the solicitor has provided their services to the third party, and not the client. Whilst the recipient of the supply can treat the VAT as input tax subject to the normal rules, in this case in line with its own partial exemption position, the client has not received a supply; it is not his input tax.

This is confirmed in HMRC Internal Manual VATSC11531:

“In the majority of legal disputes, each party employs its own lawyers to represent them and so these lawyers supply their services to their client. It is common for the court to order the loser to pay the winner’s legal costs.

Normally the parties agree the winning party will reclaim the VAT, if they are VAT registered, and the loser will pay the net amount. If the winner is not VAT registered or is partly exempt then the loser will normally pay the VAT-inclusive amount. However, this does not mean the winning party’s lawyers have supplied services to the losers – the payment is a contribution to costs and the loser cannot recover input tax on the winners’ lawyer’s fee.”

If your client is paying the costs via their insurance policy, it is important to stress to the insurer that you are unable to claim the VAT on the third-party’s costs and ask them to cover the VAT-inclusive cost in their pay-out.

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Tony joined HMRC in 2015 where he managed a cross-tax Hidden Economy team specialising in failure to notify compliance work and evasion. He developed a sound understanding of VAT as well as gaining significant knowledge of the compliance penalties regime and Schedule 36 compliance powers.

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